What’s in a yield?

Posted on October 22nd, 2012.

I have mentioned in the past that one of the biggest mistakes that income-seeking investors make is to buy income-producing investments based on their current yield without taking other factors into consideration. The fact is that a high yield does not mean an investment is a good one, and may sometimes be a sign of problems anticipated in the future – like maybe the likelihood of the dividend or distribution being cut in the near future! Yikes..I cringe to think of investors buying investments based on high yields only to lose money when the dividend is cut and the shares subsequently drop in value. That is one of the reasons I developed the Dividend Anchor Score, a security analysis tool to help with initial screening of income producing investments, I will get back to that so read on.

In my acclaimed book InSync Income, the Must Read Guide to Investing for Income in Canada, I talk a great deal about the different types of risk involved when investing in the many available income producing investments. In this post I want to focus in on a couple of key points that will hopefully help shed some initial light on the subject.

The first thing I like to discuss, which may seem pretty simple, is dividend coverage. Dividend coverage is a calculation that shows us the ability of the company to pay its dividend. The dividend coverage calculation is widely available online and I discuss it in my book as well. The calculation is useful in itself, but what I really like is the thought process itself – the idea that first off – a company should be consistently earning enough to cover its dividend.

Now when I say stuff like that it makes some investors scratch their heads, “companies pay dividends when they can’t afford to?” They may ask – Yup, sometimes. And other times their dividend may fluctuate a lot as well. So first off, keeping the explanation simple, we want to see that a company is earning enough to cover its dividend – and then some.

The second point I want to make has to do with the “fluctuating dividends” I mentioned. I have a lot to say about this topic but the main point I want to make is that stocks that have fluctuating dividends tend to be more volatile. So what do you think happens when there is a dividend cut? The stock price is likely to DECLINE, that’s what. And I think we can all agree that we want to try to avoid those particular circumstances.

And so that brings me full circle back to that security analysis tool that I mentioned, the Dividend Anchor Score. The idea behind the DA score is to compare the yield and the volatility of an investment to the yield and volatility of an alternative investment, to help differentiate and compare. An investment might pay 8% but has a history of being very volatile. Another investment might pay 7% but be less volatile. Both investments might be good choices depending on when they are purchased – the volatility might provide a windfall gain if the market rises, taking the share price of your investment with it. I explain all this in my book and I would certainly recommend a copy to anyone serious about getting the most from their income-producing investment portfolio.

Reading investment posts and books is a great way to learn but is not a substitute for professional advice. I recommend seeking the advice of an appropriate financial professional prior to making any changes to an existing strategy, or implementing a new one. Invest with advice for best results.

Frank Weiler

The Income Investor’s Advocate

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